Pipes Being Laid To Break The Visa-Mastercard Oligopoly – Mastercard Incorporated (NYSE:MA)

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There are few long-term price charts that are as beautiful as that of Visa (V) and Mastercard’s (MA). The two payment giants have been the benefactors of low post-crisis competition in the payments space, a significant increase in non-physical cash payments, data processing innovations, the “death of cash”, and the growth of e-commerce. In fact, if you invested $10K in Mastercard at the bottom of the financial crisis, you’d now have $220K, while you’d “only” have 56K if you bought SPY:

ChartData by YCharts

Despite significant returns and high valuations, the vast majority of analysts are bullish on both companies. Indeed, they both have a track record of high revenue growth and have raised profit margins to very high levels. I agree with the consensus view that e-commerce will continue to be a significant driver of revenue growth for the companies, but the bigger the pie, the more competition will come.

Put simply, the long-term prospects of these companies are not as rosy as they used to be. While Newton’s third law of motion does not apply to stocks, high stable margins and seemingly endless growth are likely to increase competition and could finally crack the payment industry’s significant moats. In my opinion, there are three major risks that jeopardize revenue growth for Visa and Mastercard: emerging competition, increasing regulatory threats, and a likely economic slowdown.

A Global Rebellion Against Fees

Payment companies rely on the value of their network, and Visa and Mastercard have, by far, the most integrated and extensive global payment networks, making it very difficult for competitors like Apple Pay (AAPL), PayPal (PYPL), and Alipay to gain enough network market share to be profitable if they tried to compete directly.

The barriers to entry in the payments industry are immense, but technological innovation is antiquating much of the payment industry’s fee structure. For example, Discover Financial Services (DFS) has no foreign transaction fees, which should attract customers (cross-border fees make up about a quarter of Mastercard’s revenue), but the company has an objectively worse network (as many Discover cardholders know all too well).

Because of these immense network advantages, global governments are beginning to scrutinize the industry. In the U.S., Europe, and many other places, there is rising popular pressure on breaking monopolies and oligopolies. In the U.S., the Federal Trade Commission recently probed Visa and Mastercard to see if some retailers are being blocked from routing digital payments over alternative debit networks like Pulse, NYCE, and Star. In Europe, the European Commission cracked down on interchange fees last year.

Even more, just a few days ago, the Royal Bank of Australia called for a possible end to the automatic use of Visa and Mastercard and instead regulate that the country’s own far-cheaper system “EFTPOS” be used.

Interchange fees are charged to merchants accepting cards and are paid to banks issuing Mastercards/Visa cards. If those fees are reduced, banks will see lower profits from credit cards and likely request lower gross dollar volume fees. If governments continue to jab at the network power of these two companies, the tide may shift and finally crack the doors open to disruptors.

U.S. Interchange fees are currently a $110 billion industry, and banks currently earn $52 billion in income on them, higher than the interest they charge on the underlying loans. If interchange fees drop due to competition/regulation, it will almost certainly cause banks to look to issuing their own cards similarly to Discover and Amex (AXP).

Visa is fully aware of this threat and announced a complete revamp of its interchange fee structure earlier this week, noting that, “The U.S. credit interchange structure has been largely unchanged for the past 10 years.” The company plans to make interchange fees vary vendor to vendor depending on their business. This includes increased fees on e-commerce (thereby increasing the chance that Amazon (AMZN) will disrupt) and decreased fees on in-store merchants (possibly to appease small business-friendly regulators). The company plans for these changes to go into effect in April and October of 2020.

A Note on Digital Currency

Of course, there is also the digital currency disruption angle. I have my doubts that cryptocurrencies will ever be a stable store of value, but distributed networks like Ripple aim to drastically undercut traditional transaction fees. In my personal opinion, disruption won’t probably won’t be from any of the major cryptocurrencies today, it is only clear that the gates to do so are finally opening.

One possible example is JPMorgan’s (JPM) “JPM Coin“, which is a digital coin that allows for free instantaneous payments. It is currently only a prototype, but with strong institutional backing, it could hypothetically take some of the payment industry’s business.

As I discussed in a recent article “Silvergate Capital: Banking On Crypto“, the dominant bank for cryptocurrency businesses, Silvergate Capital (SI), has also developed its own free/instant institutional payment network called “Silvergate exchange network”.

For now, these networks are only in the hands of major institutions, but it goes to show that many pipes are being laid by Visa/Mastercard’s own customers seemingly exploring the possibility of direct competition.

Mastercard vs. Visa

I do not believe that either of the earnings of either company will take a significant hit from this threat soon – it is largely existential. That said, we must consider how much growth is priced into these stocks. If they fail to hit growth targets, significant declines could arrive.

To demonstrate, take a look at the revenue growth, “P/E”, and profit margins of each company:

ChartData by YCharts

As you can see, both have been growing revenue at a high pace, with an average of about 11% per year. They also both maintain incredibly high profit margins of around 50% and rarely experience losses.

Over the past 120 years, stocks in the S&P 500 have held a median “P/E” ratio of 15X, which I use as a benchmark valuation for stocks that are expected to grow revenue at GDP pace. Further, in today’s frothy valuation market, companies in the S&P 500 have a median “P/E” of 25X. Thus, we can assume that there is about 70-200% total future discounted revenue growth baked into the valuations of these two companies.

Where will this much growth come from? I believe it is fair to assume that the trend will be toward lower transaction fees due to competition between the two, and potential external disruption/regulation will slow growth. Total non-cash transactions will likely continue to climb, but that does not necessarily mean that Visa/Mastercard will maintain their moats.

There are additional negative growth catalysts to keep in mind. While both market themselves as “technology companies”, their business model is cyclical, and a decline in global retail sales brought on by a recession or the growing Coronavirus threat would hamper growth. Obviously, with margins as high as they are today, their bottom lines are unlikely to fall significantly, but their growth is likely to. Further, the impact of the Coronavirus on China’s production may also eventually limit the supply of goods globally and lower/slow transactions.

Between Mastercard and Visa, I believe that Mastercard is a better short opportunity due to its higher valuation, which makes its stock price more sensitive to changes in growth expectations. Mastercard’s current valuation premium to Visa implies a level of revenue growth that is highly unlikely to be sustainable, and I’d bet that the valuation gap between them will close before either enters a bear market.

One could even do a pairs trade on the two by short-selling Mastercard and hedging with Visa. Obviously, I’m long-term bearish on both, but both companies have very high momentum today, and there is some probability that they move parabolically higher similarly to Tesla (TSLA).

As you can see in their total return ratio below, MA is at a long-term resistance level compared to V:

ChartData by YCharts

In my opinion, the pairs trade is likely to offer much more alpha than directly short-selling Mastercard, as it largely removes the risk of a parabolic short-squeeze on either company.

Bottom Line

I’m sure many are enchanted with the tremendous growth rates of Mastercard and Visa. Indeed, that growth may not fade quite yet, but competitive and regulatory pressures seem to be growing at a much faster pace than the market expects.

It is true that previous calls for “disruption of the payments industry” have not yet impacted their bottom line, but that does not mean they won’t. Visa and Mastercard rely on extensive networks that act as a (very) significant barrier to entry. However, once the network is broken enough (be it from regulation or competition), there is a decent chance that it breaks completely. This has happened before in social media (Myspace, AOL, etc.) and in many other network-centric industries.

For now, the payments oligopoly seems intact. It will require significant work on behalf of merchants and banks to create competing payment networks, but with 50%+ profit margins in the industry, the competition will come. Outside of the U.S., there is already significant pushback against fees, and I’d bet that ex. U.S. revenue will see lower-than-expected growth over the coming year.

That said, contrary to the opinions of some, nothing can go up forever without significant drawdowns. For now, both are capitalizing on what is essentially economic rent generated by oligopoly power, but challengers’ infrastructure is being laid, and I imagine it will crack their networks in the coming years, lowering growth expectations today.

Overall, I believe that both Visa and Mastercard are “sells”, but that it may not be a great time to short either without a hedge considering their high momentum. If I look to make the trade, it will be a long Visa-short Mastercard pairs trade, as I expect their valuation gap to close from here. Eventually, both will be great short opportunities.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in MA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: May go long Visa to hedge as well.

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